Cadence reports poor results

Venice, Florida — On July 23, Cadence Design Systems, Inc. reported second quarter 2008 revenue of $329 million, compared to revenue of $391 million reported for the same period in 2007. On a GAAP basis, Cadence recognized net income of $5 million, or $0.02 per share on a diluted basis, in the second quarter of 2008, compared to net income of $60 million, or $0.20 per share on a diluted basis, in the same period in 2007.

As is traditional in the EDA industry, Cadence also reported non-GAAP results. Using this method, net income in the second quarter of 2008 was $38 million, or $0.14 per share on a diluted basis, as compared to $91 million, or $0.30 per share on a diluted basis, in the same period in 2007.

In prepared statements during the analysts' webcast that followed the release of the financial results, Mike Fister, President and CEO, stated that during the quarter Cadence had significant wins at Matsushita, Reneas, and Broadcom. He also reminded the audience that the company had just introduced a new product, C-to-Silicon Compiler at the beginning of July. he attributed the disappointing results in part to the general slow economic environment stating that " Many of our customers are facing uncertainty or outright slowdowns in their own businesses. "
He went on to say that a number of customers are choosing to amortize their current technology investments, staying with the same process nodes and methodologies longer while other customers are demanding greater flexibility in terms and access due to market conditions in order to close business.

Mr Fister's explanations regarding the strength of the company and its near term viability to meet third quarter forecast were predictable. He cited strong customers' relations, continue investment in R&D, the planned introduction of new products, and the commitment by the corporate staff to long term success.

Kevin Palatnik, Senior VP and CFO, reminded the analysts on the call that Non-GAAP operating margin was 15% and that the operating cash flow was $77 million. Both items indicate that Cadence's financial health is not in any immediate danger even if compared with the same period in 2007, operating cash flow showed a decline of $24 million or $8 million per month. Cash and cash equivalents were $837 million at quarter-end. He further detailed the revenue mix by stating that product revenue was $195 million, maintenance revenue was $100 million, and services revenue was $34 million. Revenue mix by geography in Q2 was 49 percent for the Americas, 21 percent for Europe, 18 percent for Japan and 12 percent for Asia.

The Mentor Affair
Mike Fister reported the status of the negotiations for the proposed acquisition of Mentor Graphics. There have been no direct discussions between Cadence and Mentor since the June 16th announcement of the proposed acquisition by Cadence. During the webcast Mr. Fister stated: " We continue to believe that our proposal is extremely compelling for Mentor Graphics shareholders. Our proposal provides them with a unique opportunity to realize, with certainty, a significant cash premium value for their investment in Mentor Graphics.
It remains our preference to work cooperatively with Mentor Graphics to complete the acquisition. Although we have not had discussions with Mentor Graphics concerning our acquisition proposal, we continue to communicate to them and their advisors, both privately and publicly, that we want to meet with them immediately to begin substantive discussions regarding our proposal."

Cadence has filed the required HSR notices with the U.S. regulatory authorities and, as of July 11th, has acquired, through open market transactions, approximately 4.3 million shares of Mentor Graphics, giving it approximately 4.7% of Mentor's outstanding common stock. The fact that Mike specifically used the term "open market transactions" indicates that the shares have been purchased at market value and not at the tender offer price of $16.00 per share.

During the question and answer period both Mr. Fister and Mr. Palatnik reiterated that the financing for the acquisition was not yet in place, since Cadence is still negotiating with its lenders to obtain the best possible financial terms, but they also pointed out that the deal is not conditional on Cadence finding financing. Cadence projects that ,even with the significantly reduced outlook, it can repay the financing within four years, given the projected cash flow of the combined company.

It is clear that the level of skepticism among financial analysts has raised considerably after the Q2 results were announced, with a few of them expressing reservations during the question and answer period of the webcast. It seems apparent that the acquisition of Mentor would be the quickest and less risky way to fix Cadence revenue problem, at least in the short term.

Financial Outlook
In describing the expected results for the third quarter and for the entire fiscal year Kevin Palatnik underscored the change in accounting practices just made at the company by shifting to a ratable 90% mix in recognizing license revenue. For Q3 Cadence expects revenue to be in the range of $235 to $245 million. GAAP EPS should be in the range of a loss of (25) to (27) cents, and non-GAAP EPS in the range of a loss of (9) to (11) cents.
For the year 2008, the company expect revenue to be in the range of $1.12 to $1.14 billion. Year-end backlog should be approximately $2.0 billion with order levels at approximately $ 1.1 billion.

Mr. Palatnik added, "A key metric for us, particularly as we move through this transition, is cash flow from operations. We are projecting cash flow from operations of $175 million, down from a prior estimate of $350 million, in 2008, and $250 million in 2009." Capital expenditures for 2008 should be in the range of $70 million with an additional $37 million for work to complete our new engineering building. Cadence projects that for 2009 capital expenditures would remain at a level similar to this year.

Not surprisingly, many analysts on the call questioned both the assumptions and the projections. Rich Valera asked: " Last year you guys had a bookings of $1.6B versus 1.1B this year. Bookings are not affected by a model transition but are a strength of your current business. A quarter ago you expected $1.5B. Did environment deteriorate?" Mr. Palatnik conceded that the environment had gotten worse. Given the fact that I have often written about the fact that commodity products do not, in most cases, need to be manufactured with the latest process available, it is surprising that a company that believes itself to be the leader in EDA is only now admitting it and is suffering such significant financial consequences from it.

observed that we are looking at a 30-40% decline in product bookings vs. '07, and asked if Cadence is having difficulties being recognized for the value of its products. While, not surprisingly, neither Mr. Fister not Mr. Palatnik would answer the question directly, you might want to read my opinion (Cadence greener grass) about such difficulties.

The day following the announcement Cadence's stock fell over 30% reaching a 13-year low of $6.99 after RBC Capital downgraded the stock to sector perform from outperform. The stock closed at $7.40 on July 28th, a loss of 27.95% since before the announcement. During the webcast Mike Fister, in response to an analyst's question, stated that Cadence will slow down investments in "cash cow" products and concentrate on system level and manufacturability products. This statement did, almost certainly, contributed to the downgrade.

The statement during the webcast by Cadence that "customers are staying on older process nodes longer" motivated RBC Capital analyst Mahesh Sanganeria to state that "It would seem as though Moore's law is dead" in a note to clients.

It is also clear that Cadence's position in the acquisition of Mentor has weakened and will, most probably, have to be justified in different terms. We are no longer looking at the leader in the sector consolidating businesses, but at a weaker company exploring a short term fix to its market and financial positions.

As Kevin, Dr. Tan and Dr. Shoven look for the next CEO, I think there are a few lessons from the past 4 years that are very evident about running a company such as a Cadence: 1. Cadence may be very small compared to a division in a large company such as an Intel but it is a very complex diversified company -- the strategic/operational experiences of a single product division don't directly translate. The learning curve for outsiders is very long. The most analogous industry to EDA is Enterprise-SW -- Even complex diversified Enterprise-SW companies such as SAP and Oracle have very different ECO-systems and business strategies. The experience doesn't translate very easily. 2. Cadence needs a CEO who will not need another 2-4 years to figure out what's real and what's BS? Believe me, there is a lot of BS that gets airtime, especially during these periods of transition. 3. The next CEO will likely have to be a bold thinker. Cadence should dispassionately assess what does it want to be. Is it really better off continuing to be a broad-line supplier or should it become a smaller, more differentiated company and spin out other businesses in the portfolio. The broad scope is actually leading to mediocrity across the portfolio. Cadence has a large portfolio of undifferentiated me-too products that provide Cadence with mass but not strength (differentiation). If it chooses to remain a broad-line supplier, even then it must evolve it's portfolio to remain competitive.
4. Unless the BoD can convince Carrol Bartz or a Joe Costello or even Tony Zingale to lead Cadence, they are better of finding an EDA veteran who has GM level experience of a large business in EDA. Here is a short list of names that come to mind:
* Moshe Gavrielov -- Already the CEO at Zilinx so probably not interested
* Sanjiv Kaul -- He was the GM of Synopsys' Implementation business during its growth phase in the late Nineties and early part of this decade. He has also significant leadership experience in the Verification and DFM parts of EDA
* Roy Jewel -- I remember that ~6-7 years ago Magma started to gain traction in the market soon after Roy joined them as a COO after his successful stints at Avant and TMA before then. I remember it as I was at a competitor who was focused on Magma. Other EDA executives who could/should be on the short list:
* Wally Rhines -- Via merger with Mentor
* Manoj Gandhi -- Long, steady, successful stint at the helm of the Verification business at Synopsys. The SystemVerilog and VCS-NTB turned the tables on Cadence and Verisity -- Not easily done.
* Joe Swicki -- Long successful stint as the GM of Mentor's Physical Verification + DFM business. Don't know much more than that.
* John Chilton -- Played a lot of different Estaff roles at Synopsys